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Recent Economic Developments in Latvia and the Way Forward

Recent Economic Developments in Latvia and the Way Forward. Ilmārs Rimšēvičs Governor of the Bank of Latvia. Latvia: severe recession after years of double digit growth. How did we get into this situation?. GDP growth, %. 2.

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Recent Economic Developments in Latvia and the Way Forward

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  1. Recent Economic Developments in Latvia and the Way Forward Ilmārs Rimšēvičs Governor of the Bank of Latvia

  2. Latvia: severe recession after years of double digit growth. How did we get into this situation? GDP growth, % 2

  3. Growth was fuelled by massive capital inflows after the EU accession, adding considerably to a build up of excessive domestic demand and real estate bubble Bank of Latvia Government budget Commercial Banks FDI EU Funds Labour remittances 1 EUR = 0.702804 LVL

  4. Excessive demand and overheating pressures added to a build-up of imbalances Inflation, % Wages and productivity, 2004=100 4

  5. Fiscal policy was insufficiently ambitious; no precautionary savings were made during economic boom General government budget balance, % of GDP 5

  6. Domestic contraction coincided with global woes, turning an orderly correction into a hard landing Latvia could no longer weather the storm alone when its 2nd largest bank signaled the need of government rescue Parex bank (stylized facts): • in terms of assets – 2nd largest • number of settlement accounts, credit transfers volume – 3rd • by value of credit transfers – 4th largest • attracted resident deposits – 3rd largest • non-resident deposits - market leader 6

  7. Public finance outlook deteriorated - international assistance was called upon to avoid severe fiscal crisis General government budget balance, % of GDP 7

  8. Key elements of the international support package • International support available in amount of 7.5bn euro (credit line), based on the following policies: • Fiscal consolidation, adopting fiscal prudence framework • Tight income policies to reverse excessive wage increases • Banking system stabilisation, strengthening of supervision • Structural reforms (public administration, healthcare, education, labour market, etc) • Maintenance of the current (narrow-band) exchange rate peg • A clear exit strategy: expeditious euro introduction (as early as 2012) 8

  9. Devaluation is not a solution for Latvia Loss of credibility would result in drastic consequences Positive effects on exporters are uncertain No improvement of current account Many corporates would face negative equity immediately Court system unable to cope with the sharpgrowth in thenumber of insolvency cases No motivation to improve efficiency and productivity 9

  10. Devaluation is not a solution for Latvia • Even in case of a moderate (15%) devaluation an average pensioner would face a decrease of up to one third in the real subsistence level with theprices of imported energy, medicine and other productsgoing up. • With increasing number of bankruptcies unemployment would sky-rocket, forcing many families to strugglefor making ends meet.

  11. Internal adjustment is Latvia’s way • It allows time for structural reforms,thus smoothing adjustment • Stimulates improvement of public sector efficiency • More gradual adjustment motivates businesses to raise productivity • Less corporate bankruptcies - less costs to the economy • Wages are flexible in Latvia

  12. Worsening growth outlook poses challenges to keep fiscal situation on track GDP growth, % * - forecast

  13. Wages are flexible in Latvia, wage correction underway Wage growth, seasonally adjusted, % q-o-q 13

  14. Strong disinflation will support wage correction 12-month inflation (%) 14

  15. Current account has already reached balance ... Current account, % of GDP * - preliminary data

  16. ... That is not surprising, as the current account deficit was driven by overly excessive domestic absorption rather than fundamental competitiveness problems Real Effective Exchange Rates (1999 = 100; HICP deflated) 16

  17. Latvia: challenges ahead • Firm implementation of fiscal targets • Restoration of bankingsector stability; lending support • Stimulation of economy • Euro introduction as early as 2012 17

  18. So far, substantial progress has been made towards resolving Parex issues • Agreement reached on the rollover of syndicated liabilities, first payment made • Increased capital base to reach capital adequacy of 11% • EBRD acquires 25% of ownership • Search of strategic investor

  19. Even though LVL is pegged to EUR, these are still two different currencies

  20. Fiscal performance becomes a key challengeon the road to euro in 2012 EURO EUR strategy Measurement period General government budget balance (% of GDP) 20

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